Capital budgeting

After being found acceptable in terms of payback period, aproject is subjected to evaluation by other financial capital budgeting techniques.A second evaluation is usually performed beca

n a few short years, Amazon.com has evolved from an

idea to the best-known firm on the Internet The firm’s

president, Jeff Bezos, commands the attention of Wall Street

and the financial press On the morning of September 28,

1999, Amazon.com planned to make an “announcement

significantly affecting the world of e-commerce.” The

follow-ing day, Mr Bezos stepped up to a podium in the Sheraton

Hotel in New York.

“Sixteen months ago Amazon.com was a place where

you could find books,” Bezos began, hands folded behind

his back as he paced the stage “Tomorrow Amazon.com

will be a place where you can find anything.” With that, he

introduced the latest installment of the Amazon potboiler:

the serialization story of one company’s ambitious plan to

take over the world—the e-commerce world that is.

Throughout 1999, Amazon.com has been on the move.

On average it has announced a major initiative every six

weeks In February it bought 46% of Drugstore.com In

March it launched online auctions—two days after rival

eBay announced a secondary stock offering In May the

company took a 35% piece of HomeGrocer.com In June,

54% of Pets.com In July, 49% of Gear.com That same

month Amazon opened two new online shops: toys and electronics October’s announcement was Z-shops (an on- line mall) and All Product Search (a product browser) Forget about Amazon.com as the Wal-Mart of the Web Bezos is aiming for something even bigger So big,

in fact, that it hasn’t been invented yet “I get asked a lot, Are you trying to be the Wal-Mart of the Web?” says Bezos.

“The truth is, we’re not trying to be the Anything of the Web We’re genetically pioneers Everybody here wants to

do something completely new I wake up every morning trying to make sure I can confound journalists and pundits who try to encapsulate us in an eight-second sound bite.”

In Bezos’ vision, Amazon.com will be the center of the e-commerce universe Books, pet food, tennis shoes, banjos; whatever e-shoppers want, they can buy it, or locate

it, on Amazon.com Picture Amazon as an octopus, its tacles reaching out all over the Web The potential payoff is huge Investors certainly think so After Amazon announced Z-shops and All Product Search, its stock rose 23%, to $80

ten-a shten-are “This is so big, so importten-ant, thten-at you hten-ave to be invested in it,” says Morris Mark, a portfolio manager who added to his Amazon stake after the announcement.

Amazon.com’s future will be determined by the success of the investments it is

making today Although the risks may be large, the potential payoff is

propor-tionate Choosing the assets in which an organization will invest is one of the most

important business decisions of managers In almost every organization,

invest-ments must be made in some short-term working capital assets, such as

merchan-dise inventory, supplies, and raw material Organizations must also invest in

cap-ital assets that are used to generate future revenues; cost savings; or distribution,

service, or production capabilities A capital asset can be a tangible fixed asset

(such as a piece of machinery or a building) or an intangible asset (such as a

cap-ital lease or a patent)

The acquisition of capital assets is often part of the solution to many of the

issues discussed in this text For example, the improvement of quality may depend

on the acquisition of new technology and investment in training programs

Reengi-neering of business processes often involves investment in higher technology; and

mergers and acquisitions involve decisions to invest in other companies These

ex-amples illustrate capital asset decisions

Financial managers, assisted by cost accountants, are responsible for capital

budgeting Capital budgeting is “a process for evaluating proposed long-range

projects or courses of future activity for the purpose of allocating limited resources.”1

SOURCE : Katrina Brooker, “Amazon vs Everybody,” Fortune (November 8, 1999), pp 120–128 © 1999 Time Inc Reprinted by permission.

601

http://www.amazon.comI

capital asset

capital budgeting

1

Institute of Management Accountants (formerly National Association of Accountants), Statements on Management

Account-ing Number 2: Management AccountAccount-ing Terminology (Montvale, N.J.: NAA, June 1, 1983), p 14.

The process includes planning for and preparing the capital budget as well as viewing past investments to assess and enhance the effectiveness of the process.The capital budget presents planned annual expenditures for capital projects forthe near term (tomorrow to 5 years from now) and summary information for thelong term (6 to 10 years) The capital budget is a key instrument in implementingorganizational strategies.

re-Capital budgeting involves comparing and evaluating alternative projects within

a budgetary framework A variety of criteria are applied by managers and tants to evaluate the feasibility of alternative projects Although financial criteria areused to assess virtually all projects, today more firms are also using nonfinancialcriteria The nonfinancial criteria are critical to the assessment of activities that havefinancial benefits that are difficult to quantify For example, high-technology invest-ments and investments in research and development (R&D) are often difficult toevaluate using only financial criteria One firm in the biotechnology industry usesnine criteria to evaluate the feasibility of R&D projects These criteria are presented

accoun-in Exhibit 14–1

By evaluating potential capital projects using a portfolio of criteria, managers can

be confident that all possible costs and contributions of projects have been sidered Additionally, the multiple criteria allow for a balanced evaluation of short-and long-term benefits, the fit with existing technology, and the roles of projects

con-in both marketcon-ing and cost management For this biotechnology company, the use

of multiple criteria ensures that projects will be considered from the perspectives

of strategy, marketing, cost management, quality, and technical feasibility

Note that one of the criteria in Exhibit 14–1 is financial rate of return on vestment Providing information about the financial returns of potential capitalprojects is one of the important tasks of cost accountants This chapter discusses

in-a vin-ariety of techniques thin-at in-are used in businesses to evin-aluin-ate the potentiin-al finin-an-cial costs and contributions of proposed capital projects Several of these techniquesare based on an analysis of the amounts and timing of project cash flows

finan-1. Potential for proprietary position.

2. Balance between short-term and long-term projects and payoffs.

3. Potential for collaborations and outside funding.

4. Financial rate of return on investment.

5. Need to establish competency in an area.

6. Potential for spin-off projects.

7. Strategic fit with the corporation’s planned and existing technology, manufacturing capabilities, marketing and distribution systems.

8. Impact on long-term corporate positioning.

9. Probability of technical success.

SOURCE : Suresh Kalahnanam and Suzanne K Schmidt, “Analyzing Capital Investments in New Products,” ment Accounting (January 1996), pp 31–36 Reprinted from Management Accounting Copyright by Institute of Man- agement Accountants, Montvale, N.J.

Manage-E X H I B I T 1 4 – 1

Project Evaluation Criteria—R&D

Projects

USE OF CASH FLOWS IN CAPITAL BUDGETING

Capital budgeting investment decisions can be made using a variety of techniquesincluding payback period, net present value, profitability index, internal rate of re-turn, and accounting rate of return All but the last of these methods focus on the

amounts and timing of cash flows (receipts or disbursements of cash) Cash

re-ceipts include the revenues from a capital project that have been earned and lected, savings generated by the project’s reductions in existing operating costs,and any cash inflow from selling the asset at the end of its useful life Cash dis-

col-Why do most capital budgeting

methods focus on cash flows?

cash flow

1

bursements include asset acquisition expenditures, additional working capital

in-vestments, and costs for project-related direct materials, direct labor, and overhead

Any investment made by an organization is expected to earn some type of

re-turn, such as interest, cash dividends, or operating income Because interest and

dividends are received in cash, accrual-based operating income must be converted

to a cash basis for comparison purposes Remember that accrual accounting

rec-ognizes revenues when earned, not when cash is received, and recrec-ognizes

ex-penses when incurred regardless of whether a liability is created or cash is paid

Converting accounting income to cash flow information puts all investment returns

on an equivalent basis

Interest cost is a cash outflow associated with debt financing and is not part

of the project selection process The funding of projects is a financing, not an

in-vestment, decision A financing decision is a judgment regarding the method of

raising capital to fund an investment Financing is based on the entity’s ability to

issue and service debt and equity securities On the other hand, an investment

decision is a judgment about which assets to acquire to achieve an entity’s stated

objectives Cash flows generated by the two types of decisions should not be

com-bined Company management must justify the acquisition and use of an asset prior

to justifying the method of financing that asset

Including receipts and disbursements caused by financing with other project

cash flows conceals a project’s true profitability because financing costs relate to

the total entity The assignment of financing costs to a specific project is often

ar-bitrary, which causes problems in comparing projects that are to be acquired with

different financing sources In addition, including financing effects in an investment

decision creates a problem in assigning responsibility Investment decisions are

typ-ically made by divisional managers, or by top management after receiving input

from divisional managers Financing decisions are typically made by an

organiza-tion’s treasurer in conjunction with top management

Cash flows from a capital project are received and paid at different points in

time over the project’s life Some cash flows occur at the beginning of a period,

some during the period, and some at the end To simplify capital budgeting

analy-sis, most analysts assume that all cash flows occur at a specific, single point in

time—either at the beginning or end of the time period in which they actually

occur The following example illustrates how cash flows are treated in capital

budgeting situations

financing decision investment decision

CASH FLOWS ILLUSTRATED

Assume that a variety of capital projects are being considered by eRAGs, a small

company selling electronic versions of books and magazines on the Internet One

investment being considered by eRAGs is the acquisition of an Internet company,

Com.com, that markets electronic advertising to other firms selling Internet

prod-ucts and services

eRAGs’ expected acquisition costs and expected cash income and expenses

as-sociated with the acquisition appear in Exhibit 14–2 This detailed information can

be simplified to a net cash flow for each year For eRAGs, the project generates a

net negative flow in the first year and net positive cash flows thereafter This cash

flow information for eRAGs can be illustrated through the use of a time line

Time Lines

A time line visually illustrates the points in time when cash flows are expected

to be received or paid, making it a helpful tool for analyzing cash flows of a

cap-ital investment proposal Cash inflows are shown as positive amounts on a time

line and cash outflows are shown as negative amounts

time line

The following time line represents the cash flows from eRAGs’ potential ment in Com.com.

Net cash flow ⫺ $8,700 ⫹ $1,200 ⫹ $2,500 ⫹ $3,400 ⫹ $2,900 ⫹ $1,800 ⫹ $1,500 ⫹ $ 900

On a time line, the date of initial investment represents time point 0 because thisinvestment is made immediately Each year after, the initial investment is repre-sented as a full time period, and periods serve only to separate the timing of cashflows Nothing is presumed to happen during a period Thus, for example, cashinflows each year from royalties earned are shown as occurring at the end of,rather than during, the time period A less conservative assumption would showthe cash flows occurring at the beginning of the period

Payback Period

The information on timing of net cash flows is an input to a simple and

often-used capital budgeting technique called payback period This method measures

the time required for a project’s cash inflows to equal the original investment Atthe end of the payback period, a company has recouped its investment

In one sense, payback period measures a dimension of project risk by ing on the timing of cash flows The assumption is that the longer it takes to re-cover the initial investment, the greater is the project’s risk because cash flows inthe more distant future are more uncertain than relatively current cash flows An-other reason for concern about long payback periods relates to capital reinvest-ment The faster that capital is returned from an investment, the more rapidly itcan be invested in other projects

focus-Payback period for a project having unequal cash inflows is determined by cumulating cash flows until the original investment is recovered Thus, using theinformation shown in Exhibit 14–2 and the time line presented earlier, the Com.cominvestment payback period must be calculated using a yearly cumulative total ofinflows as follows:

ac-CASH OUTFLOWS (000s)

Due diligence costs: $ 500 (to be incurred immediately) Acquisition cost: 8,200 (to be incurred immediately) Cost to reorganize 700 (to be incurred in year 1)

Year Annual Amount Cumulative Total

At the end of the third year, all but $1,600 of the initial investment of $8,700

has been recovered The $2,900 inflow in the fourth year is assumed to occur

evenly throughout the year Therefore, it should take approximately 0.55 ($1,600

⫼ $2,900) of the fourth year to cover the rest of the original investment, giving

a payback period for this project of 3.55 years (or slightly less than 3 years and

7 months)

When the cash flows from a project are equal each period (an annuity), the

payback period is determined as follows:

Payback Period ⫽ Investment ⫼ AnnuityAssume for a moment that an investment being considered by eRAGs requires

an initial investment of $10,000 and is expected to generate equal annual cash

flows of $4,000 in each of the next 5 years In this case, the payback period would

be equal to the $10,000 net investment cost divided by $4,000 or 2.5 years (2 years

and 6 months)

Company management typically sets a maximum acceptable payback period

as one of the financial evaluation criteria for capital projects If eRAGs has set four

years as the longest acceptable payback period, this project would be acceptable

under that criterion As indicated in the accompanying News Note, companies have

a bias of investing in projects with a quick payoff The News Note also highlights

the government’s role in funding longer term investments

annuity

Dear Uncle Sam: Please Send Money

N E W S N O T E

G E N E R A L B U S I N E S S

It may sound strange to hear a Silicon Valley executive

credit the birth of such industries as the Internet and

lo-cal-area networks to the prescience of the U.S

govern-ment But in many cases it is the government that has

provided the seeds, and industry that has provided the

water and light, to cultivate the technological innovations

that are improving the nation’s economy and quality of

life Unfortunately, from 1987 to 1995, federal investment

in basic research sank by 2.6% per year As a fraction

of gross domestic product, the federal investment in

re-search and development is about half of what it was 30

years ago.

Meanwhile, the information technology sector alone

has more than doubled its annual R&D investment over

the last 10 years to a current level of $30 billion In this

searing-hot competitive environment, however, most of these expenditures must be allocated to short-term prod- uct development It isn’t feasible for the private sector to assume responsibility for long-term, high-risk research when shareholders require solid quarterly returns on investment.

A newly released study by the Council on tiveness confirms these findings and highlights both the long-term returns from, and the dangers of being com- placent about, the U.S investment in R&D For every dol- lar spent on basic research, we can expect a 50 cents per year increase in national output.

Competi-SOURCE : Adapted from Eric A Benhamou, “R&D Needs Washington’s Support,” The Wall Street Journal (June 17, 1999), p A26.

Most companies use payback period as only one way of financially judging aninvestment project After being found acceptable in terms of payback period, aproject is subjected to evaluation by other financial capital budgeting techniques.

A second evaluation is usually performed because the payback period method nores three things: inflows occurring after the payback period has been reached,the company’s desired rate of return, and the time value of money These issuesare incorporated into the decision process using discounted future cash flows

ig-DISCOUNTING FUTURE CASH FLOWS

Money has a time value associated with it; this value is created because interest ispaid or received on money.2

For example, the receipt of $1 today has greater valuethan the same sum received one year from today because money held today can

be invested to generate a return that will cause it to accumulate to more than $1over time This phenomenon encourages the use of discounted cash flow tech-niques in most capital budgeting situations to account for the time value of money

Discounting future cash flows means reducing them to present value amounts

by removing the portion of the future values representing interest This “imputed”amount of interest is based on two considerations: the length of time until the cashflow is received or paid and the rate of interest assumed After discounting, all fu-ture values associated with a project are stated in a common base of current dol-

lars, also known as their present values Cash receipts and disbursements

occur-ring at the beginning of a project (time 0) are already stated in their present valuesand are not discounted

Information on capital projects involves the use of estimates; therefore, havingthe best possible estimates of all cash flows (such as initial project investment) isextremely important Care should be taken also to include all potential future in-flows and outflows To appropriately discount cash flows, managers must estimatethe rate of return on capital required by the company in addition to the project’s

cost and cash flow estimates This rate of return is called the discount rate and is

used to determine the imputed interest portion of future cash receipts and

expen-ditures The discount rate should equal or exceed the company’s cost of capital

(COC), which is the weighted average cost of the various sources of funds (debtand stock) that comprise a firm’s financial structure.3

For example, if a companyhas a COC of 10 percent, it costs an average of 10 percent of each capital dollarannually to finance investment projects To determine whether a capital project is

a worthwhile investment, this company should generally use a minimum rate of

10 percent to discount its projects’ future cash flows

A distinction must be made between cash flows representing a return of

cap-ital and those representing a return on capcap-ital A return of capcap-ital is the recovery

of the original investment or the return of principal, whereas a return on capital

is income and equals the discount rate multiplied by the investment amount Forexample, $1 invested in a project that yields a 10 percent rate of return will grow

to a sum of $1.10 in one year Of the $1.10, $1 represents the return of capitaland $0.10 represents the return on capital The return on capital is computed foreach period of the investment life For a company to be better off by making aninvestment, a project must produce cash inflows that exceed the investment madeand the cost of capital To determine whether a project meets a company’s desiredrate of return, one of several discounted cash flow methods can be used

2 The time value of money and present value computations are covered in Appendix 1 of this chapter These concepts are sential to understanding the rest of this chapter; be certain they are clear before continuing.

es-3 All examples in this chapter use an assumed discount rate or cost of capital The computations required to find a company’s cost of capital rate are discussed in any principles of finance text.

DISCOUNTED CASH FLOW METHODS

Three discounted cash flow techniques are the net present value method, the

prof-itability index, and the internal rate of return Each of these methods is defined

and illustrated in the following subsections

Net Present Value Method

The net present value method determines whether the rate of return on a

proj-ect is equal to, higher than, or lower than the desired rate of return Each cash

flow from the project is discounted to its present value using the rate specified by

the company as the desired rate of return The total present value of all cash

out-flows of an investment project subtracted from the total present value of all cash

inflows yields the net present value (NPV) of the project Exhibit 14–3 presents

net present value calculations, assuming the use of a 12 percent discount rate The

cash flow data are taken from Exhibit 14–2

The factors used to compute the net present value are obtained from the

pres-ent value tables provided in Appendix A at the end of the text Each period’s cash

flow is multiplied by a factor obtained from Table 1 (PV of $1) for 12 percent and

the appropriate number of periods designated for the cash flow Table 2 in

Ap-pendix A is used to discount annuities rather than single cash flows and its use is

demonstrated in later problems

The net present value of the Com.com investment is $815,000 The NPV

rep-resents the net cash benefit or net cash cost to a company acquiring and using the

proposed asset If the NPV is zero, the actual rate of return on the project is equal

to the required rate of return If the NPV is positive, the actual rate is greater than

the required rate If the NPV is negative, the actual rate is less than the required

rate of return Note that the exact rate of return is not indicated under the NPV

method, but its relationship to the desired rate can be determined If all estimates

about the investment are correct, the Com.com investment being considered by

eRAGs will provide a rate of return greater than 12 percent

Had eRAGs chosen any rate other than 12 percent and used that rate in

con-junction with the same facts, a different net present value would have resulted For

example, if eRAGs set 15 percent as the discount rate, a NPV of $8,000 would have

resulted for the project (see Exhibit 14–4) Net present values at other selected

dis-count rates are given in Exhibit 14–4 The computations for these values are made

in a manner similar to those at 12 and 15 percent (To indicate your understanding

of the NPV method, you may want to prove these computations.)

How are the net present value and profitability index of a project measured?

net present value method

net present value

E X H I B I T 1 4 – 3

Net Present Value Calculation for Com.com Investment

The table in Exhibit 14–4 indicates that the NPV is not a single, unique amount,but is a function of several factors First, changing the discount rate while holdingthe amounts and timing of cash flows constant affects the NPV Increasing the dis-count rate causes the NPV to decrease; decreasing the discount rate causes NPV toincrease Second, changes in estimated amounts and/or timing of cash inflows andoutflows affect the net present value of a project Effects of cash flow changes onthe NPV depend on the changes themselves For example, decreasing the estimate

of cash outflows causes NPV to increase; reducing the stream of cash inflows causesNPV to decrease When amounts and timing of cash flows change in conjunctionwith one another, the effects of the changes are determinable only by calculation.The net present value method, although not providing the actual rate of return

on a project, provides information on how that rate compares with the desiredrate This information allows managers to eliminate from consideration any projectproducing a negative NPV because it would have an unacceptable rate of return.The NPV method can also be used to select the best project when choosing amonginvestments that can perform the same task or achieve the same objective.The net present value method should not, however, be used to compare in-dependent projects requiring different levels of initial investment Such a compar-ison favors projects having higher net present values over those with lower netpresent values without regard to the capital invested in the project As a simpleexample of this fact, assume that eRAGs could spend $200,000 on Investment A

or $40,000 on Investment B Investment A’s and B’s net present values are $4,000and $2,000, respectively If only NPVs were compared, the company would concludethat Investment A was a “better” investment because it has a larger NPV However,Investment A provides an NPV of only 2 percent ($4,000 ⫼ $200,000) on the in-vestment, whereas Investment B provides a 5 percent ($2,000 ⫼ $40,000) NPV.Logically, organizations should invest in projects that produce the highest return perinvestment dollar Comparisons of projects requiring different levels of investmentare made using a variation of the NPV method known as the profitability index

Profitability IndexThe profitability index (PI) is a ratio comparing the present value of a project’s

net cash inflows to the project’s net investment The PI is calculated as

PI ⫽ Present Value of Net Cash Flows ⫼ Net Investment

DISCOUNT RATE ⴝ15%

Cash Flow Time Amount Discount Factor Present Value

Net present value with 5% discount rate: $3,202 Net present value with 10% discount rate: $1,419 Net present value with 20% discount rate: $(1,121)

E X H I B I T 1 4 – 4

Net Present Value Calculation

for Com.com Investment

profitability index

The present value of net cash flows equals the PV of future cash inflows minus

the PV of future cash outflows The PV of net cash inflows represents an output

measure of the project’s worth, whereas the net investment represents an input

measure of the project’s cost By relating these two measures, the profitability

in-dex gauges the efficiency of the firm’s use of capital The higher the inin-dex, the

more efficient is the capital investment

The following information illustrates the calculation and use of a profitability

index eRAGs is considering two investments: a training program for employees

costing $720,000 and a series of Internet servers costing $425,000 Corporate

man-agers have computed the present values of the investments by discounting all

fu-ture expected cash flows at a rate of 12 percent Present values of the expected

net cash inflows are $900,000 for the training program and $580,000 for the servers

Dividing the PV of the net cash inflows by initial cost gives the profitability index

for each investment Subtracting asset cost from the present value of the net cash

inflows provides the NPV Results of these computations are shown below

Although the training program’s net present value is higher, the profitability index

indicates that the server package is a more efficient use of corporate capital.4

Thehigher PI reflects a higher rate of return on the server package than on the train-

ing program The higher a project’s PI, the more profitable is that project per

in-vestment dollar

If a capital project investment is made to provide a return on capital, the

prof-itability index should be equal to or greater than 1.00, the equivalent of an NPV

equal to or greater than 0 Like the net present value method, the profitability

in-dex does not indicate the project’s expected rate of return However, another

dis-counted cash flow method, the internal rate of return, provides the expected rate

of return to be earned on an investment

Internal Rate of Return

A project’s internal rate of return (IRR) is the discount rate that causes the

pres-ent value of the net cash inflows to equal the prespres-ent value of the net cash

out-flows It is the project’s expected rate of return If the IRR is used to determine

the NPV of a project, the NPV is zero By examining Exhibits 14–3 and 14–4, it is

apparent that eRAGs investment in Com.com would generate an IRR very close to 15

percent because a discount rate of 15 percent resulted in an NPV very close to $0

The following formula can be used to determine net present value:

NPV ⫽ ⫺Investment ⫹ PV of Cash Inflows ⫺ PV of Cash Outflows other

than the investment

⫽ ⫺Investment ⫹ Cash Inflows (PV Factor) ⫺ Cash Outflows (PV

Factor)

Capital project information should include the amounts of the investment, cash

in-flows, and cash outflows Thus, the only missing data in the preceding formula are

the present value factors These factors can be calculated and then be found in

the present value tables The interest rate with which the factors are associated is

4

Two conditions must exist for the profitability index to provide better information than the net present value method First,

the decision to accept one project must require that the other project be rejected The second condition is that availability of

How is the internal rate of return

on a project computed? What does it measure?

internal rate of return

4

the internal rate of return The internal rate of return is most easily computed forprojects having equal annual net cash flows When an annuity exists, the NPV for-mula can be restated as follows:

NPV ⫽ ⫺Net Investment ⫹ PV of Annuity Amount

⫽ ⫺Net Investment ⫹ (Cash Flow Annuity Amount ⫻ PV Factor)The investment and annual cash flow amounts are known from the expected dataand net present value is known to be zero at the IRR The IRR and its presentvalue factor are unknown To determine the internal rate of return, substitute knownamounts into the formula, rearrange terms, and solve for the unknown (the PVfactor):

NPV ⫽ ⫺Net Investment ⫹ (Annuity ⫻ PV Factor)

0 ⫽ ⫺Net Investment ⫹ (Annuity ⫻ PV Factor)Net Investment ⫽ (Annuity ⫻ PV Factor)

Net Investment ⫼ Annuity ⫽ PV FactorThe solution yields a present value factor for the number of annuity periods cor-responding to the project’s life at an interest rate equal to the internal rate of re-turn Finding this factor in the PV of an annuity table and reading the interest rate

at the top of the column in which the factor is found provides the internal rate ofreturn

To illustrate an IRR computation for a project with a simple annuity, tion in Exhibit 14–5 pertaining to eRAGs’ potential investment in a quality controlsystem is used The quality control system would be installed immediately andwould generate cost savings over the five-year life of the system The system has

informa-no expected salvage value

The NPV equation is solved for the present value factor

NPV ⫽ ⫺Net Investment ⫹ (Annuity ⫻ PV Factor)

$0 ⫽ ⫺$99,560 ⫹ ($29,000 ⫻ PV Factor)

$99,560 ⫽ ($29,000 ⫻ PV Factor)

$99,560 ⫼ $29,000 ⫽ PV Factor

3.43 ⫽ PV FactorThe PV of an ordinary annuity table (Table 2, Appendix A) is examined tofind the internal rate of return A present value factor is a function of time and thediscount rate In the table, find the row representing the project’s life (in this case,five periods) Look across the table in that row for the PV factor found upon solv-ing the equation In row 5, a factor of 3.4331 appears under the column headed 14percent Thus, the internal rate of return for this machine is very near 14 percent.Using interpolation, a computer program, or a programmable calculator the exact

IRR can be found.5

A computer program indicates the IRR of the quality controlsystem is 13.9997 percent

Exhibit 14–6 plots the net present values that result from discounting the

qual-ity control system cash flows at various rates of return For example, the NPV at

4 percent is $28,407 and the NPV at 15 percent is ⫺$2,041 (These computations

are not provided here, but can be performed by discounting the $29,000 annual

cash flows and subtracting $99,560 of investment cost.)

The internal rate of return is located on the graph’s horizontal axis at the point

where the NPV equals zero (13.9997 percent) Note that the graph reflects an

in-verse relationship between rates of return and NPVs Higher rates yield lower

pres-ent values because, at the higher rates, fewer dollars need to be currpres-ently invested

to obtain the same future value

Manually finding the IRR of a project that produces unequal annual cash flows

is more complex and requires an iterative trial-and-error process An initial

esti-mate is made of a rate believed to be close to the IRR and the NPV is computed

If the resulting NPV is negative, a lower rate is estimated (because of the inverse

relationship mentioned above) and the NPV is computed again If the NPV is

pos-itive, a higher rate is tried This process is continued until the net present value

equals zero, at which time the internal rate of return has been found

The project’s internal rate of return is then compared with management’s

preestablished hurdle rate, which is the rate of return specified as the lowest

ac-ceptable return on investment Like the discount rate mentioned earlier, this rate

should generally be at least equal to the cost of capital In fact, the hurdle rate is

commonly the discount rate used in computing net present value amounts If a

project’s IRR is equal to or greater than the hurdle rate, the project is considered

viable from a financial perspective As indicated in the following passage, hurdle

rates are no longer simply an American concept

Faced with higher capital costs, Japanese managers are beginning to embrace

such previously little-known Western concepts as “hurdle rates” and “required rates

of return.” That’s a big switch for executives who once concerned themselves only

with market share Said Tsunehiko Ishibashi, general manager of finance for

Mitsubishi Kasei, a major petrochemical company: “As a result of the higher cost

of capital, the profitability standards for new investments must be raised.”6

The higher the internal rate of return, the more financially attractive is the vestment proposal In choosing among alternative investments, however, managerscannot look solely at the internal rates of return on projects The rates do not re-flect the dollars involved An investor would normally rather have a 10 percent re-turn on $1,000 than a 100 percent return on $10!

in-Using the internal rate of return has three drawbacks First, when uneven cashflows exist, the iterative process is inconvenient Second, unless present value ta-bles are available that provide factors for fractional interest rates, finding the pre-cise IRR on a project is difficult These two problems can be eliminated with theuse of a computer or a programmable calculator The last problem is that it is pos-sible to find several rates of return that will make the net present value of the cashflows equal zero This phenomenon usually occurs when there are net cash inflows

in some years and net cash outflows in other years of the investment project’s life(other than time 0)

In performing discounted cash flow analyses, accrual-based accounting tion sometimes needs to be converted to cash flow data One accrual that deservesspecial attention is depreciation Although depreciation is not a cash flow item, it hascash flow implications because of its deductibility for income tax purposes

informa-The internal rate of return on an

investment must clear the

com-pany’s designated hurdle rate.

That hurdle rate will be raised as

the company’s cost of debt and

equity capital increases.

THE EFFECT OF DEPRECIATION ON AFTER-TAX CASH FLOWS

Income taxes are an integral part of the business environment and decision-makingprocess in our society Tax planning is a central part of management planning andhas a large impact on overall business profitability Managers typically make deci-sions only after examining how company taxes will be affected by those decisions

In evaluating capital projects, managers should use after-tax cash flows to determineproject acceptability

Note that depreciation expense is not a cash flow item Although no funds arepaid or received for it, depreciation on capital assets, similar to interest on debt,affects cash flows by reducing a company’s tax obligation Thus, depreciation pro-

vides a tax shield against the payment of taxes The tax shield produces a tax benefit equal to the amount of taxes saved (the depreciation amount multiplied

by the tax rate) The concepts of tax shield and tax benefit are shown on the lowing income statements The tax rate is assumed to be 40 percent

fol-How do taxation and

depreciation methods affect

cash flows?

tax shield

tax benefit

5

No Depreciation Deduction Depreciation Deduction

The tax shield is the depreciation expense amount of $37,500 The tax benefit is the

difference between $15,000 of tax expense on the first income statement and $0 of

tax expense on the second income statement The tax benefit is also equal to the

40 percent tax rate multiplied by the depreciation tax shield of $37,500, or $15,000

Because taxes are reduced by $15,000, the pattern of cash flows is improved

It is the depreciation for purposes of computing income taxes rather than the

amount used for financial accounting purposes that is relevant in discounted cash

flow analysis Income tax laws regarding depreciation deductions are subject to

re-vision In making their analyses of capital investments, managers should use the

most current tax regulations for depreciation Different depreciation methods may

have significant impacts on after-tax cash flows For a continuously profitable

busi-ness, an accelerated method of depreciation, such as the modified accelerated cost

recovery system (MACRS), allowed for U.S tax computations, will produce higher

tax benefits in the early years of asset life than will the straight-line method These

higher tax benefits will translate into a higher net present value over the life of

the investment project

Changes in the availability of depreciation methods or in the length of an asset’s

depreciable life may dramatically affect projected after-tax cash flows and also affect

the net present value, profitability index, and internal rate of return expected from

the capital investment Because capital projects are analyzed and evaluated before

investments are made, managers should be aware of the inherent risk of tax law

changes Original assumptions made about the depreciation method or asset life

may not be valid by the time an investment is actually made and an asset is placed

into service However, once purchased and placed into service, an asset can

gen-erally be depreciated using the method and tax life allowed when the asset was

placed into service regardless of the tax law changes occurring after that time

Changes may also occur in the tax rate structure Rate changes may be relatively

unpredictable For example, the maximum federal corporate tax rate for many years

was 46 percent; the Tax Reform Act of 1986 lowered this rate to 34 percent, and

the present top marginal U.S tax rate is 35 percent.7

A tax rate reduction lowers thetax benefit provided by depreciation because the impact on cash flow is lessened

Tax law changes (such as asset tax-life changes) can cause the expected outcomes

of the capital investment analysis to vary from the project’s actual outcomes.8

To illustrate such variations, assume that eRAGs is considering investing in a

new Internet site The site will require an investment of $540,000 in computer

hard-ware and softhard-ware Assume these assets have a 10-year economic life and would

produce expected net annual cash income of $110,000 Assume the company’s

after-tax cost of capital is 11 percent Further assume that corporate assets are depreciated

on a straight-line basis for tax purposes.9

To simplify the presentation, the authors have elected to ignore a tax rule requirement called the half-year (or mid-quarter)

convention that applies to personal assets and a mid-month convention that applies to most real estate improvements Under tax

law, only a partial year’s depreciation may be taken in the year an asset is placed into service The slight difference that such a

In late 2000, prior to making the Internet site investment, eRAGs’ cost countant, Jill Flowers, calculated the project’s net present value The results of hercalculations are shown in Exhibit 14–7 under Situation A Note that depreciation

ac-is added to income after tax to obtain the amount of after-tax cash flow Eventhough depreciation is deductible for tax purposes, it is still a noncash expense.The present value amounts are obtained by multiplying the after-tax cash flows bythe appropriate PV of an annuity factor from Table 2 in Appendix A at the end ofthe text

The NPV evaluation technique indicated the acceptability of the capital vestment At the time of Ms Flowers’ analysis, eRAGs’ tax rate was 30 percent andthe tax laws allowed a 10-year depreciable life on this property

in-ASSUMED FACTS

Expected annual before-tax cash flows 110,000

Situation A: Tax rate of 30% (actual rate in effect) Situation B: Tax rate of 25%

Situation C: Tax rate of 40%

SITUATION A—NPV CALCULATIONS ASSUMING AN 11% DISCOUNT RATE Cash Flow Time Amount Discount Factor Present Value

SITUATION B—NPV CALCULATIONS ASSUMING AN 11% DISCOUNT RATE Cash Flow Time Amount Discount Factor Present Value

SITUATION C—NPV CALCULATIONS ASSUMING AN 11% DISCOUNT RATE Cash Flow Time Amount Discount Factor Present Value

Because Ms Flowers was concerned about proposed changes in the U.S tax

rate, she also analyzed the project assuming that tax rates changed Exhibit 14–7

shows the different after-tax cash flows and net present values that result if the

same project is subjected to either a 25 percent (Situation B) or 40 percent

(Situ-ation C) tax rate

This example demonstrates the expected NPV change when a different tax rate

is used If the tax rate changes to either 25 or 40 percent, the NPV changes A

de-crease in the tax rate makes the Internet site a more acceptable investment, based

on its net present value, and an increase in the tax rate has the opposite effect

Understanding how depreciation and taxes affect the various capital

budget-ing techniques will allow managers to make the most informed decisions about

capital investments.10

Well-informed managers are more likely to have confidence

in capital investments made by the company if they can justify the substantial

re-source commitment required That justification is partially achieved by considering

whether a capital project fits into strategic plans To be confident of their

conclu-sions, managers must also comprehend the assumptions and limitations of each

capital budgeting method

10

These examples have all considered the investment project as a purchase If a leasing option exists, the classification of the

lease as operating or capital will affect the amounts deductible for tax purposes A good illustration of this is provided in “The

ASSUMPTIONS AND LIMITATIONS OF METHODS

As summarized in Exhibit 14–8, each financial capital budget evaluation method

has its own underlying assumptions and limitations To maximize benefits of the

capital budgeting process, managers should understand the similarities and

differ-ences of the various methods and use several techniques to evaluate a project

All of the methods have two similar limitations First, except to the extent that

payback indicates the promptness of the investment recovery, none of the

meth-ods provides a mechanism to include management preferences with regard to the

timing of cash flows This limitation can be partially overcome by discounting cash

flows occurring further in the future at higher rates than those in earlier years,

as-suming that early cash flows are preferred Second, all the methods use single,

de-terministic measures of cash flow amounts rather than probabilities This limitation

can be minimized through the use of probability estimates of cash flows Such

es-timates can be input into a computer program to determine a distribution of

an-swers for each method under various conditions of uncertainty

What are the underlying assumptions and limitations of each capital project evaluation

method?

6

THE INVESTMENT DECISION

Management must identify the best asset(s) for the firm to acquire to fulfill the

company’s goals and objectives Making such an identification requires answers to

the following four subhead questions

Is the Activity Worthy of an Investment?

A company acquires assets when they have value in relation to specific activities

in which the company is engaged For example, Amazon.com invests heavily in

product and service development because that is the primary path to new

rev-enues (the activity) Before making decisions to acquire assets, company

manage-ment must be certain that the activity for which the assets will be needed is

wor-thy of an investment

An activity’s worth is measured by cost-benefit analysis For most capital geting decisions, costs and benefits can be measured in monetary terms If the dol-lars of benefits exceed the dollars of costs, then the activity is potentially worth-while In some cases, though, benefits provided by capital projects are difficult toquantify However, difficulty in quantification is no reason to exclude benefits fromcapital budgeting analyses In most instances, surrogate quantifiable measures can

bud-be obtained for qualitative bud-benefits For example, bud-benefits from investments in daycare centers for employees’ children may be estimable based on the reduction inemployee time off and turnover At a minimum, managers should attempt to sub-jectively include such benefits in the analytical process

In other circumstances, management may know in advance that the monetarybenefits of the capital project will not exceed the costs, but the project is essentialfor other reasons For example, a company may consider renovating the employeeworkplace with new carpet, furniture, paint, and artwork The renovation would

Payback Method

■ Speed of investment recovery is the key consideration.

■ Timing and size of cash flows are accurately predicted.

■ Risk (uncertainty) is lower for a shorter payback project.

■ Cash flows after payback are ignored.

■ Cash flows and project life in basic method are treated as deterministic without explicit consideration of probabilities.

■ Time value of money is ignored.

■ Cash flow pattern preferences are not explicitly recognized.

Net Present Value

■ Discount rate used is valid.

■ Timing and size of cash flows are accurately predicted.

■ Life of project is accurately predicted.

■ If the shorter lived of two projects is selected, the proceeds

of that project will continue to earn the discount rate of

return through the theoretical completion of the longer lived

project.

■ Cash flows and project life in basic method are treated as deterministic without explicit consideration of probabilities.

■ Alternative project rates of return are not known.

■ Cash flow pattern preferences are not explicitly recognized.

■ IRR on project is not reflected.

Profitability Index

■ Same as NPV.

■ Size of PV of net inflows relative to size of present value of

investment measures efficient use of capital.

■ Same as NPV.

■ A relative answer is given but dollars of NPV are not reflected.

Internal Rate of Return

■ Hurdle rate used is valid.

■ Timing and size of cash flows are accurately predicted.

■ Life of project is accurately predicted.

■ If the shorter lived of two projects is selected, the proceeds

of that project will continue to earn the IRR through the

theoretical completion of the longer lived project.

■ The IRR rather than dollar size is used to rank projects for funding.

■ Dollars of NPV are not reflected.

■ Cash flows and project life in basic method are treated as deterministic without explicit consideration of probabilities.

■ Cash flow pattern preferences are not explicitly recognized.

■ Multiple rates of return can be calculated on the same project.

E X H I B I T 1 4 – 8

Assumptions and Limitations of

Capital Budgeting Methods

Accounting Rate of Return (Presented in Appendix 2 of this chapter)

■ Effect on company accounting earnings relative to average

investment is key consideration.

■ Size and timing of increase in company earnings,

investment cost, project life, and salvage value can be

accurately predicted.

■ Cash flows are not considered.

■ Time value of money is not considered.

■ Earnings, investment, and project life are treated as deterministic without explicit consideration of probabilities.

not make employee work any easier or safer, but would make it more

comfort-able Such a project may be deemed “worthy” regardless of the results of a

cost-benefit analysis Companies may also invest in unprofitable products to maintain

market share of a product group, and, therefore, protect the market position of

profitable products One of the most difficult investments to evaluate is

technol-ogy, which is addressed in the accompanying News Note

Which Assets Can Be Used for the Activity?

The determination of available and suitable assets to conduct the intended

activ-ity is closely related to the evaluation of the activactiv-ity’s worth Management must

have an idea of how much the needed assets will cost to determine whether the

activity should be pursued As shown in Exhibit 14–9, management should gather

the following specific monetary and nonmonetary information for each asset to

make this determination: initial cost, estimated life and salvage value, raw

mate-rial and labor requirements, operating costs (both fixed and variable), output

ca-pability, service availability and costs, maintenance expectations, and revenues to

be generated (if any) As mentioned in the previous section, information used in

a capital project analysis may include surrogate, indirect measures Management

must have both quantitative and qualitative information on each asset and

recog-nize that some projects are simply more crucial to the firm’s future than others

This point is illustrated in the News Note below

Of the Available Assets for Each Activity,

Which Is the Best Investment?

Using all available information, management should select the best asset from the

candidates and exclude all others from consideration In most instances, a

com-pany has a standing committee to discuss, evaluate, and approve capital projects In

judging capital project acceptability, this committee should recognize that two types

of capital budgeting decisions must be made: screening and preference decisions

Technology: What’s It Worth?

N E W S N O T E

G E N E R A L B U S I N E S S

Remember the promises of expert systems, the

paper-less office, and other hype that technology created? Is

technology all sizzle and no substance, or can technology

re-gain its credibility? One of the ways of re-establishing

confidence is by managing technology investments and

by having realistic measurements that are meaningful to

your business.

Evaluating the benefits of technology is not easy for two

reasons We know that information itself is useless unless

it assists in making better decisions that could not have

been made without the use of that information What makes

investment in technology difficult to measure is that having

all the information available before making a decision

guar-antees only information overload, not the right decision As

well, the value of technology depends on what the

busi-ness goals are that it is supporting, and to what degree

technology is instrumental in achieving these goals.

You can’t measure the value of information by ining the size of the disk storage, the number of PCs in the organization, the boxes of reports printed, or on-line queries processed, because none of these items is valu- able until they are used in the business More money spent on technology does not guarantee more value to the business: it is how technology is used that matters, not how much it costs Expensive technology that only automates the existing manual processes will not add value to the business unless it provides additional ben- efits that do not exist in the manual environment.

exam-SOURCE : Reprinted from an article, “Managing Technology Investments,” ing in CMA Management Magazine (formerly CMA Magazine) by Catherine A.

appear-A screening decision determines whether a capital project is desirable based on

some previously established minimum criterion or criteria If the project does notmeet the minimum standard(s), it is excluded from further consideration The sec-

ond decision is a preference decision in which projects are ranked according to

their impact on the achievement of company objectives

Deciding which asset is the best investment requires the use of one or several

of the evaluation techniques discussed previously Some techniques may be used

to screen the projects as to acceptability; other techniques may be used to rankthe projects in order of preferability Although different companies use differenttechniques for screening and ranking purposes, payback period is commonly usedonly for screening decisions The reasons for this choice are that payback focusesonly on the short run and does not consider the time value of money The re-maining techniques may be used to screen or rank capital projects

Of the “Best Investments” for All Worthwhile Activities,

in Which Ones Should the Company Invest?

Although many worthwhile investment activities exist, each company has limitedresources available and must allocate them in the most profitable manner There-fore, after choosing the best asset for each activity, management must decide which

E X H I B I T 1 4 – 9

Capital Investment Information

$

Necessary Information About Capital Investment Projects

January 2010 January 2000

Estimated Life and Salvage Value

36

Service Availability and Costs

Maintenance Expectations

$

$50,000 Initial Cost

Operating Costs

Raw Material and Labor Requirements

Output Capability

$

Revenues (if any)

screening decision

preference decision

activities and assets to fund Investment activities may be classified as mutually

ex-clusive, independent, or mutually inclusive

Mutually exclusive projects fulfill the same function One project will be

chosen from such a group, causing all others to be excluded from further

consid-eration because they would provide unneeded or redundant capability A proposal

under consideration may be to replace a current asset with one that provides the

same basic capabilities If the company keeps the old asset, it will not buy the

new one; if the new one is purchased, the old asset will be sold Thus, the two

assets are mutually exclusive For example, if a bakery decided to buy a new

de-livery truck, it would no longer need its existing truck The existing truck would

be sold to help finance the new truck

Other investments may be independent projects because they have no

spe-cific bearing on one another For example, the acquisition of an office

microcom-puter system is not related to the purchase of a factory machine These project

de-cisions are analyzed and accepted or rejected independently of one another

Although limited resources may preclude the acquisition of all acceptable projects,

the projects themselves are not mutually exclusive

Management may be considering certain investments that are all related to a

primary project, or mutually inclusive projects In a mutually inclusive situation,

if the primary project is chosen, all related projects are also selected Alternatively,

rejection of the primary project will dictate rejection of the others For example,

when a firm chooses to invest in new technology, investing in an employee

train-ing program for the new technology may also be necessary

Exhibit 14–10 shows a typical investment decision process in which a

com-pany is determining the best way to provide transportation for its sales force

An-swers to the four questions asked in the subheadings to this section are provided

for the transportation decision

To ensure that capital funds are invested in the best projects available,

man-agers must carefully evaluate all projects and decide which ones represent the most

effective and efficient use of resources—a difficult determination The evaluation

Activity—Provide transportation for a sales force of 10 people.

1 Is the activity worthy of an investment?

Yes; this decision is based on an analysis of the cost of providing transportation in

relationship to the dollars of gross margin to be generated by the sales force.

2 Which assets can be used for the activity?

Available: Bus passes, bicycles, motorcycles, automobiles (purchased), automobiles

(leased), automobiles (currently owned), small airplanes.

Infeasible: Bus passes, bicycles, and motorcycles are rejected as infeasible because of

inconvenience and inability to carry a reasonable quantity of merchandise; airplanes are

rejected as infeasible because of inconvenience and lack of proximity of landing sites to

customers.

Feasible: Various types of automobiles to be purchased (assume asset options A

through G); various types of leasing arrangements (assume availability of leases 1

through 5); current fleet.

Gather all relevant quantitative and qualitative information on all feasible assets (assets

A–G; leases 1–5; current fleet).

3 Which asset is the best investment?

Compare all relevant information and choose the best asset candidate from the purchase

group (assume Asset D) and the lease group (assume Lease 2).

4 Which investment should the company make?

Compare the best asset candidate from the purchase group (Asset D) and the lease

group (Lease 2); this represents a mutually exclusive, multiple-candidate project decision.

The best candidate is found to be type D assets Compare the type D assets to current

fleet; this is a mutually exclusive, replacement project The best investment is to sell the

old fleet and purchase a new fleet of 10 type D automobiles.

process should consider activity priorities, cash flows, and risk of all projects ects should then be ranked in order of their acceptability Ranking may be requiredfor both independent projects and mutually exclusive projects Ranking mutu-ally exclusive projects is required to select the best project from the set of alter-natives Ranking independent projects is required to efficiently allocate scarce cap-ital to competing uses.

Proj-RANKING MULTIPLE CAPITAL PROJECTS

When managers are faced with an accept/reject decision for a single asset, all value-of-money evaluation techniques will normally point to the same decision alter-native A project is acceptable under the NPV method when it has a nonnegativenet present value Acceptability of a capital asset is also indicated by a profitabilityindex (PI) of 1.00 or more Because the PI is an adaptation of the NPV method, thesetwo evaluation techniques will always provide the same accept/reject decision

time-To be acceptable using the IRR model, a capital acquisition must have an ternal rate of return equal to or greater than the specified hurdle rate The IRRmethod gives the same accept/reject decision as the NPV and PI methods if thehurdle rate and the discount rate used are the same

in-More often, however, managers are faced with choosing among multiple ects Multiple project decisions require that a selection ranking be made This sec-tion of the chapter considers the use of the net present value, profitability index,and internal rate of return techniques for ranking mutually exclusive projects Pay-back period also can be used to rank multiple projects However, it does not pro-vide as much useful information as NPV, PI, and IRR, because cash flows beyondthe payback period are ignored

proj-Managers can use results from the evaluation techniques to rank projects indescending order of acceptability For the NPV and PI methods, rankings are based,respectively, on magnitude of NPV and PI index Although based on the same fig-ures, the NPV and PI methods will not always provide the same order of rankingbecause the former is a dollar measure and the latter is a percentage When theinternal rate of return is used, rankings of multiple projects are based on expectedrate of return Rankings provided by the IRR method will not always be in thesame order as those given by the NPV or PI methods

Conflicting results arise because of differing underlying reinvestment tions of the three methods The reinvestment assumption presumes cash flows

assump-released during a project’s life are reinvested until the end of the project’s life TheNPV and PI techniques assume that released cash flows are reinvested at the dis-count rate which, at minimum, should be the cost of capital (COC) The IRR methodassumes reinvestment of released cash flows can be made at the expected inter-nal rate of return, which may be substantially higher than the COC If it is, the IRRmethod may provide a misleading indication of project success because additionalprojects may not be found that have such a high return

Three situations are discussed in the following subsections to illustrate flicting rankings of multiple projects In each situation the weighted average cost

con-of capital is the discount rate used to compute NPV as well as the hurdle rateagainst which to measure IRR

Multiple Projects—Equal Lives, Constant Cash Flows, Unequal Investments

eRAGs has gathered the following information pertaining to two potential projects.One project under consideration is the purchase of software that would improve theefficiency of processing customer orders The other investment being contemplated

How do managers rank

investment projects?

7

reinvestment assumption

is a customer service training program for the sales staff Data on these projects

are as follows:

Software Training Program

Note that in this example an assumed COC of 9 percent is used as the discount rate

The time lines, NPV, and PI computations appear in Exhibit 14–11 for both projects

The amounts on the time lines are shown in thousands of dollars The IRR is

ap-proximated from the present value of an annuity table (Table 2, Appendix A), and

the actual rate can be found using a computer or programmable calculator

The net present value model indicates that the better investment for eRAGs is

the software with a NPV of $11,843 However, in applying the profitability index

or internal rate of return models, the training program would be selected because

it has a higher PI and a higher IRR Because these projects do not serve the same

purpose, company management would most likely evaluate the selection based on

priority needs rather than results of specific capital project evaluations In the

ab-sence of a need to ration capital, eRAGs may invest in both projects

The IRR is approximately 10.19%; calculator computations verify this finding.

The IRR is approximately 11.73%; calculator computations verify this finding.

E X H I B I T 1 4 – 1 1

Multiple Projects; Conflicting Rankings

Multiple Projects—Unequal Lives, Constant but Unequal Cash Flows, Unequal Investments

The second illustration of conflicting rankings again compares the software andtraining programs but with a new set of assumptions The cost of capital is still as-sumed to be 9 percent The facts now reflect different lives and different invest-ment and annual cash flows

Software Training Program

The time lines for the two investments are as follows:

be selected by eRAGs If the internal rate of return method is used to choose tween the two projects, the software appears to be the better investment

be-SOFTWARE Cash Flow Time Amount Discount Factor Present Value

PI ⫽ $816,837 ⫼ $800,000 ⫽ 1.02 IRR factor ⫽ $800,000 ⫼ $210,000 ⫽ 3.8095 (annuity for 5 periods) The IRR is approximately 9.81%; calculator computations verify this finding.

TRAINING PROGRAM Cash Flow Time Amount Discount Factor Present Value

PI ⫽ $608,828 ⫼ $591,500 ⫽ 1.03 IRR factor ⫽ $591,500 ⫼ $110,000 ⫽ 5.3773 (annuity for 5 periods) The IRR is approximately 9.78%; calculator computations verify this finding.

E X H I B I T 1 4 – 1 2

Multiple Projects; Conflicting

Rankings

Rankings using the internal rate of return are misleading because of the

rein-vestment assumption The IRR method assumes that the cash inflows of $210,000

each year from the software investment will be reinvested at a rate of 9.81 percent;

the $110,000 of cash flows from the training program are assumed to be reinvested

at 9.78 percent The NPV method, however, assumes reinvestment of the cash flows

at the cost of capital of 9 percent, which is a more reasonable rate of return The

NPV computations show the training program to be the better investment

A formal method is available for choosing the better investment For eRAGs’

management to select the better investment, the difference in the annual cash flows

between the software and training program investments must first be determined

The cash flow differences are then evaluated as if they resulted from a separate

investment opportunity Because the software package requires a higher

invest-ment than the training program, the software package is used as the comparison

base The investment opportunity resulting from the cash flow differences is

re-ferred to here as project difference If project difference provides a positive net

pres-ent value, the software investmpres-ent is ranked higher than the training program This

higher ranking is assigned because the additional investment required for the

soft-ware is more than compensated for by the additional cash flows If project

differ-ence shows a negative net present value, the training program is the better

invest-ment The NPV of project difference is negative as shown in Exhibit 14–13 using

present value factors from Table 2, Appendix A

Multiple Projects—Equal Lives, Equal Investments,

Unequal Cash Flows

eRAGs’ management is interested in two additional projects: a joint venture to

de-velop a new Web site that would market classic comic books and a marketing

re-search study for a large traditional retailer The rere-search study is somewhat unique

in that no payment would be received from the large retailer until the completion

of the project The company’s cost of capital and discount rate are 9 percent This

NET CASH FLOWS

NET PRESENT VALUE CALCULATION—PROJECT DIFFERENCE

Cash Flow Time Amount Discount Factor Present Value

set of projects illustrates another conflicting ranking situation; the relevant projectdata follow:

Joint Venture Research Study

Net cash inflows

Because the NPV of project difference is negative, the research study is the ferred investment

pre-Exhibit 14–14 presents the net present value, profitability index, and internalrate of return computations for these projects The investment in the joint venturehas the higher IRR, but the research study has a higher NPV and PI The best se-lection depends on assumptions made about the future reinvestment rate applied

to each of the $360,000 cash flows from the joint venture

The point of indifference between the two projects occurs when the $360,000

annuity can be discounted at a certain rate (the Fisher rate) to equal $2,400,000

discounted for five years at that same rate That rate is 14.43 percent and is culated by solving for a discount rate that causes the net present values of the twoprojects to be equal If worked manually, repeated trials are used; however, a com-puter or programmable calculator can be used to find this rate quickly

cal-For reinvestment rates above 14.43 percent, the joint venture generates a highernet present value For reinvestment rates below 14.43 percent, the research study

is the superior investment

The preceding situations demonstrate that different capital budgeting tion methods often provide different rankings of projects Because of this possi-bility, managers should select one primary evaluation method for capital projects.The critical question is whether higher cash flows or a higher rate of return ispreferable The answer is that higher present cash flows are always preferable tohigher rates of return

evalua-The net present value method is considered theoretically superior to the ternal rate of return in evaluating capital projects for two reasons First, the rein-vestment assumption of the IRR method is less realistic than that of the NPV method.Second, when a project has both positive and negative net annual cash flows

in-Fisher rate

during its life, there is the arithmetic possibility that projects will have multiple

in-ternal rates of return

In addition, the net present value technique measures project results in

dol-lars rather than rates, and dollar results are the objective of investment To

illus-trate the problem that could occur by relying solely on the internal rate of return

method, consider the following question: As discussed earlier, would a manager

rather receive a 100 percent return on a $1 investment or a 10 percent return on

a $100 investment? The answer indicates the fallacy of focusing only on rates of

return

Although useful as a measure of evaluation under some circumstances, the

prof-itability index is subject to the same concern as presented in the previous paragraph

Because monetary results are the objective of investments and the PI is expressed

as a rate rather than as dollars, it can, if used by itself, lead to incorrect decisions

Taken together with other tools, however, the profitability index is a measure of

cap-ital efficiency and can assist decision makers in their financial investment analyses

JOINT VENTURE DISCOUNT RATE ⫽9%

Cash Flow Time Amount Discount Factor Present Value

PI ⫽ $1,400,292 ⫼ $1,000,000 ⫽ 1.40 IRR factor ⫽ $1,000,000 ⫼ $360,000 ⫽ 2.7778 (annuity for 5 periods)

The IRR is approximately 23.44%; calculator computations verify this finding.

RESEARCH STUDY DISCOUNT RATE ⫽9%

Cash Flow Time Amount Discount Factor Present Value

PI ⫽ $1,599,760 ⫼ $1,000,000 ⫽ 1.60 The IRR is approximately 19.14%; calculator computations verify this finding.

E X H I B I T 1 4 – 1 4

Comparison of Investment Projects

RANKING PROJECTS UNDER CAPITAL RATIONING

Managers rank capital projects to select those projects providing the greatest return

on company investment A company often finds that it has the opportunity to invest

in more acceptable projects than it has money In fact, most companies operate

under some measure of capital rationing, which means that there is an upper

dollar constraint on the amount of capital available to commit to capital asset

acqui-sition.11When capital rationing exists, the selection of investment projects must fall

capital rationing

11

Many publicly traded companies have the luxury of being able to obtain additional capital through new issuances of debt

or stock This possibility may limit the degree to which they are subject to capital rationing but does not eliminate it

Non-within the capital budget limit In these circumstances, the NPV model may notproduce rankings that maximize the value added to the firm, because it does notconsider differences in investment amount.

Capital rationing is illustrated by the following situation Assume that eRAGshas a capital budget of $7,500,000 and is considering the various investment pro-jects listed in Exhibit 14–15 By all quantitative measures except NPV, Project 1should be eliminated if the firm has only $7,500,000 available in the capital bud-get Its NPV is larger than only Project 2, but deletion of Project 2 will not permitinclusion of any other project The firm would need $8.1 million to complete allsix projects and only $7.5 million is available Because it does not help to elimi-nate Project 2, the project that would otherwise produce the smallest companyNPV and return based on either the PI or IRR technique (Project 1) should be elim-inated Relatively speaking, Project 2 is of much less interest than Projects 3, 4, 5,and 6 Project 2 does meet minimum quantitative standards though

Based on PIs, the attractiveness of the projects, in descending order, is 6, 4,

2, 5, and 3 Based on IRRs, the preferences would be 5, 3, 6, 4, and 2 Based onNPVs, the ranking would be 6, 5, 4, 3, and 2

Although managers should select one primary evaluation technique, the eRAGsexample shows that capital project evaluation should not be performed using onlyone method Each evaluation tool should be used in conjunction with others, not

to the exclusion of others Each method provides valuable information Even thenondiscounting technique of payback period can be helpful to management by in-dicating the quickness of return of investment

In making their preference decisions, many company managers set rankingcategories for projects such as those shown in Exhibit 14–16 Projects are firstscreened and placed into an appropriate category Monetary resources are allocated

to projects in a top-to-bottom fashion Within each category, projects are usuallyranked using net present value and profitability index techniques Management’sgoal should be to select those projects that, within budget constraints, will max-imize net present value to the firm Selecting projects based solely on their in-ternal rate of return rankings without consideration of the net present values may

be incorrect.12Regardless of the capital budgeting evaluation techniques used, managers mustremember that the results provided are based on estimates of future events Thefact that estimates are involved indicates that a risk is associated with the decision.All project estimates should be carefully understood and analyzed using soundjudgment Capital project proposals are being “sold” by their sponsors using dif-ferent reasons under different conditions

Potential Investment Projects

12 If the set of projects is very large, the selection of projects may require the use of integer programming techniques, which are outside the scope of this text.

CATEGORY 1—REQUIRED BY LEGISLATION

This category would include such items as pollution control equipment that has been mandated

by law Most companies can ill afford the fines or penalties that can be assessed for lack of

installation; however, these capital acquisitions may not meet the company’s minimum

established economic criteria.

CATEGORY 2—ESSENTIAL TO OPERATIONS

This category would include capital assets without which the primary functions of the

organization could not continue This category could include new purchases of capital assets

or replacements of broken or no longer usable assets For example, the purchase of a kiln

for a ceramics manufacturer would fall into this category.

CATEGORY 3—NONESSENTIAL BUT INCOME GENERATING

This category would include capital assets that would improve operations of the organization

by providing cost savings or supplements to revenue Robots in an automobile manufacturer

would be included in this group.

CATEGORY 4—OPTIONAL IMPROVEMENTS

Items in this category would be those that do not provide any cost savings or revenue

increases but would make operations run more smoothly or improve working conditions The

purchase of computer hardware or software that is faster than that currently being used and

the installation of a microwave oven in the employees’ lounge would be included here.

CATEGORY 5—MISCELLANEOUS

This category exists for “pet projects” that might be requested Such acquisitions may be more

for the benefit of a single individual and not the organization as a whole Such projects may

not even be related to organizational objectives The installation of new carpeting in a

manager’s office could be an example of this group of investments Items in this category

will normally be chosen only when the organization has substantial, unencumbered resources

at its disposal.

E X H I B I T 1 4 – 1 6

Ranking Categories for Capital Projects

COMPENSATING FOR RISK IN CAPITAL PROJECT EVALUATION

When choosing among multiple projects, managers must consider the risk or

un-certainty associated with each project In accounting, risk reflects unun-certainty about

differences between the expected and actual future returns from an investment

For example, the purchase of a $100,000, 10 percent treasury note would provide

a virtually risk-free return of $10,000 annually because treasury notes are backed

by the full faith and credit of the U.S government If the same $100,000 were

used to purchase stock, the returns could range from ⫺100 percent (losing the

entire investment) to an abnormally high return The potential for extreme

vari-ability makes the stock purchase a much more risky investment than the treasury

note

For Internet companies, one of the key variables to success is getting on-line

shoppers to access the companies’ sites One of the important variables influencing

shopper traffic is advertising For Internet companies, advertising is a capital

invest-ment—and a risky one This is illustrated in the News Note on page 628

Managers considering a capital investment should understand and compensate

for the degree of risk involved in that investment A manager may use three

ap-proaches to compensate for risk: the judgmental method, the risk-adjusted discount

rate method, and sensitivity analysis These methods do not eliminate risk, but they

do help managers understand and evaluate risk in the decision-making process

How is risk considered in capital budgeting analysis?

risk

8

http://www.yr.com

http://www.covad.com

Judgmental MethodThe judgmental method of risk adjustment allows the decision makers to use logic

and reasoning to decide whether a project provides an acceptable rate of return inrelation to its risk The decision maker is presented with all available informationfor each project, including the payback period, NPV, PI, and IRR After reviewingthe information, the decision maker chooses from among acceptable projects based

on personal judgment of the risk-to-return relationship The judgmental approachprovides no formal process for adjusting data for the risk element

Risk-Adjusted Discount Rate Method

A more formal method of taking risk into account requires making adjustments to

the discount or hurdle rate Under the risk-adjusted discount rate method, the

decision maker increases (decreases) the rate used for discounting future cash flows (outflows) to compensate for increased risk As the discount rate is increased(decreased), the present values of the cash flows are reduced (increased) There-fore, larger cash inflows are required to “cover” the investment and provide an ac-ceptable rate of return Changes in the discount rate should be reflective of thedegree of cash flow variability and timing, other investment opportunities, and cor-porate objectives If the internal rate of return is being used for project evaluation,the risk-adjusted discount rate method would increase the hurdle rate against whichthe IRR is compared for higher risk projects

in-Assume that the management of eRAGs is considering developing a new ternet service The company would operate the service for 10 years and then sell

In-it at the end of those 10 years Estimates of the development cost and annual cashflows for the service are as follows:

Initial development cost $1,500,000 After-tax net cash flows

Dustin Grosse is sitting on the edge of his seat in a

con-ference room at the ad agency Young & Rubicam in San

Francisco Grosse is the brand manager for Covad, a

Sil-icon Valley company that sells high-speed access to the

Internet, and he is about to review Y&R’s final cuts of two

television commercials They will be the centerpiece of a

$40 million, yearlong, coast-to-coast marketing campaign

designed to trumpet little-known Covad as a broadband

leader A lot is at stake, especially when you consider

that Covad’s sales for the past 12 months totaled just

over $20 million, or half its marketing budget.

Most net firms have wielded wacky, even dark humor

to set themselves apart Outpost.com showed gerbils

shooting out from a cannon, while one Beyond.com ad

features a buck-naked man working at home via the Net.

Covad flirted with off-the-wall stuff, but Bob Roblin, Covad’s

executive vice president, believes milder comedy will peal more to a mainstream audience.

ap-If Roblin is right, the upside for Covad could be mous Beyond reaching consumers and businesses, Co- vad’s campaign must make a big splash with Internet service providers Covad is a wholesaler, with no direct retail relationship with its customers If the campaign stimulates a groundswell of demand for Covad DSL, more ISPs will be driven to seek a partnership with the access provider which will boost the top line, thus achieving the ultimate, measurable goal of all the advertising.

enor-SOURCE : Edward Robinson, “The $20 Million Company and Its $40 Million

Ad Campaign,” Fortune (November 8, 1999), pp 315–316 © 1999 Time Inc Reprinted by permission.

judgmental method

risk-adjusted discount rate

method

eRAGs management uses its 9 percent cost of capital as the discount rate in

eval-uating capital projects under the NPV method However, Pierre Stellar, a board

member, feels that above-normal risk is created in this endeavor by two factors

First, revenues realized through service fees may differ from those planned

Sec-ond, the market value of the service in 10 years may vary substantially from the

estimate of $600,000

Mr Stellar wants to compensate for these risk factors by using a 15 percent

discount rate rather than the 9 percent cost of capital rate Determination of the

amount of adjustment to make to the discount rate (from 9 to 15 percent, for

ex-ample) is most commonly an arbitrary one Thus, even though a formal process is

used to compensate for risk, the process still involves a degree of judgment on

the part of the project evaluators Exhibit 14–17 presents the NPV computations

using both discount rates When the discount rate is adjusted upward, the NPV of

the project is lowered and, in this case, shows the project to be unacceptable

The same type of risk adjustment can be used for payback period or accounting

rate of return (Appendix 2) If the payback method is being used, managers may

choose to shorten the maximum allowable payback period to compensate for

in-creased risk This adjustment assumes that cash flows occurring in the more

dis-tant future are more risky than those occurring in the near future If the

account-ing rate of return (ARR) method is used, managers may increase the preestablished

acceptable rate against which the ARR is compared to compensate for risk

An-other way in which risk can be included in the decision process is through the

use of sensitivity analysis

Sensitivity Analysis

Sensitivity analysis is a process of determining the amount of change that must

occur in a variable before a different decision would be made In a capital

budget-ing situation, the variable under consideration could be the discount rate, annual

net cash flows, or project life Sensitivity analysis looks at this question: What if a

variable is different from that originally expected?

Except for the initial purchase price, all information used in capital budgeting

is estimated Use of estimates creates the possibility of introduction of errors, and

sensitivity analysis identifies an “error range” for the various estimated values over

NPV USING 9% DISCOUNT RATE

Cash Flow Time Amount Discount Factor Present Value

NPV USING 15% DISCOUNT RATE

Cash Flow Time Amount Discount Factor Present Value